Oligopoly

An oligopoly (/ɒlɪˈɡɒpəli/, from Ancient Greek ὀλίγος (olígos) "few" + πωλεῖν (poleîn) "to sell") is a market form wherein a market or industry is dominated by a small number of large sellers (oligopolists). Oligopolies can result from various forms of collusion which reduce competition and lead to higher prices for consumers. Oligopolies have their own market structure.[1]

With few sellers, each oligopolist is likely to be aware of the actions of the others. According to game theory, the decisions of one firm therefore influence and are influenced by decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market. Entry barriers include high investment requirements, strong consumer loyalty for existing brands and economies of scale.

Oligopoly is a common market form where a number of firms are in competition. As a quantitative description of oligopoly, the four-firm concentration ratio is often utilized. This measure expresses, as a percentage, the market share of the four largest firms in any particular industry. For example, as of fourth quarter 2008, if we combine total market share of Verizon Wireless, AT&T, Sprint, and T-Mobile, we see that these firms, together, control 97% of the U.S. cellular telephone market.[citation needed]

Oligopolistic competition can give rise to both wide-ranging and diverse outcomes. In some situations, particular companies may employ restrictive trade practices (collusion, market sharing etc.) in order to inflate prices and restrict production in much the same way that a monopoly does. Whenever there is a formal agreement for such collusion, between companies that usually compete with one another, this practice is known as a cartel. A prime example of such a cartel is OPEC, which has a profound influence on the international price of oil.

Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development.[citation needed] There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be actual communication between companies)–for example, in some industries there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership.

In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. This could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater when there are more firms in an industry than if, for example, the firms were only regionally based and did not compete directly with each other.

Thus the welfare analysis of oligopolies is sensitive to the parameter values used to define the market's structure. In particular, the level of dead weight loss is hard to measure. The study of product differentiation indicates that oligopolies might also create excessive levels of differentiation in order to stifle competition.

Oligopoly theory makes heavy use of game theory to model the behavior of oligopolies:

Barriers to entry are high.[3] The most important barriers are government licenses, economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms. Additional sources of barriers to entry often result from government regulation favoring existing firms making it difficult for new firms to enter the market.[4]

Number of firms

"Few" – a "handful" of sellers.[3] There are so few firms that the actions of one firm can influence the actions of the other firms.[5]

Long run profits

Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits.

Product differentiation

Product may be homogeneous (steel) or differentiated (automobiles).[4]

Perfect knowledge

Assumptions about perfect knowledge vary but the knowledge of various economic factors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and demand functions but their inter-firm information may be incomplete. Buyers have only imperfect knowledge as to price,[3] cost and product quality.

Interdependence

The distinctive feature of an oligopoly is interdependence.[6] Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore, the competing firms will be aware of a firm's market actions and will respond appropriately. This means that in contemplating a market action, a firm must take into consideration the possible reactions of all competing firms and the firm's countermoves.[7] It is very much like a game of chess, in which a player must anticipate a whole sequence of moves and countermoves in order to determine how to achieve his or her objectives; this is known as game theory. For example, an oligopoly considering a price reduction may wish to estimate the likelihood that competing firms would also lower their prices and possibly trigger a ruinous price war. Or if the firm is considering a price increase, it may want to know whether other firms will also increase prices or hold existing prices constant. This anticipation leads to price rigidity as firms will be only be willing to adjust their prices and quantity of output in accordance with a "price leader" in the market. This high degree of interdependence and need to be aware of what other firms are doing or might do is to be contrasted with lack of interdependence in other market structures. In a perfectly competitive (PC) market there is zero interdependence because no firm is large enough to affect market price. All firms in a PC market are price takers, as current market selling price can be followed predictably to maximize short-term profits. In a monopoly, there are no competitors to be concerned about. In a monopolistically-competitive market, each firm's effects on market conditions is so negligible as to be safely ignored by competitors.

Non-Price Competition

Oligopolies tend to compete on terms other than price. Loyalty schemes, advertisement, and product differentiation are all examples of non-price competition.

Oligopolies become "mature" when they realise they can profit maximise through joint profit maximising. As a result of operating in countries with enforced competition laws, the Oligopolists will operate under tacit collusion, which is collusion through an understanding that if all the competitors in the market raise their prices, then collectively all the competitors can achieve economic profits close to a monopolist, without evidence of breaching government market regulations. Hence, the kinked demand curve for a joint profit maximising Oligopoly industry can model the behaviours of oligopolists pricing decisions other than that of the price leader (the price leader being the firm that all other firms follow in terms of pricing decisions). This is because if a firm unilaterally raises the prices of their good/service, and other competitors do not follow then, the firm that raised their price will then lose a significant market as they face the elastic upper segment of the demand curve. As the joint profit maximising achieves greater economic profits for all the firms, there is an incentive for an individual firm to "cheat" by expanding output to gain greater market share and profit. In Oligopolist cheating, and the incumbent firm discovering this breach in collusion, the other firms in the market will retaliate by matching or dropping prices lower than the original drop. Hence, the market share that the firm that dropped the price gained, will have that gain minimised or eliminated. This is why on the kinked demand curve model the lower segment of the demand curve is inelastic. As a result, price rigidity prevails in such markets.

There is no single model describing the operation of an oligopolistic market.[7] The variety and complexity of the models exist because you can have two to 10 firms competing on the basis of price, quantity, technological innovations, marketing, and reputation. However, there are a series of simplified models that attempt to describe market behavior by considering certain circumstances. Some of the better-known models are the dominant firm model, the Cournot–Nash model, the Bertrand model and the kinked demand model.

The Cournot–Nash model is the simplest oligopoly model. The model assumes that there are two "equally positioned firms"; the firms compete on the basis of quantity rather than price and each firm makes an "output of decision assuming that the other firm's behavior is fixed."[8] The market demand curve is assumed to be linear and marginal costs are constant. To find the Cournot–Nash equilibrium one determines how each firm reacts to a change in the output of the other firm. The path to equilibrium is a series of actions and reactions. The pattern continues until a point is reached where neither firm desires "to change what it is doing, given how it believes the other firm will react to any change."[9] The equilibrium is the intersection of the two firm's reaction functions. The reaction function shows how one firm reacts to the quantity choice of the other firm.[10] For example, assume that the firm 1's demand function is P = (M − Q2) − Q1 where Q2 is the quantity produced by the other firm and Q1 is the amount produced by firm 1,[11] and M=60 is the market. Assume that marginal cost is CM=12. Firm 1 wants to know its maximizing quantity and price. Firm 1 begins the process by following the profit maximization rule of equating marginal revenue to marginal costs. Firm 1's total revenue function is RT = Q1P = Q1(M − Q2 − Q1) = MQ1 − Q1Q2 − Q12. The marginal revenue function is RM=∂RT∂Q1=M−Q2−2Q1{\displaystyle R_{M}={\frac {\partial R_{T}}{\partial Q_{1}}}=M-Q_{2}-2Q_{1}}.[note 1]

RM = CM

M − Q2 − 2Q1 = CM

2Q1 = (M − CM) − Q2

Q1 = (M − CM)/2 − Q2/2 = 24 − 0.5 Q2 [1.1]

Q2 = 2(M − CM) − 2Q1 = 96 − 2 Q1 [1.2]

Equation 1.1 is the reaction function for firm 1. Equation 1.2 is the reaction function for firm 2.

To determine the Cournot–Nash equilibrium you can solve the equations simultaneously. The equilibrium quantities can also be determined graphically. The equilibrium solution would be at the intersection of the two reaction functions. Note that if you graph the functions the axes represent quantities.[12] The reaction functions are not necessarily symmetric.[13] The firms may face differing cost functions in which case the reaction functions would not be identical nor would the equilibrium quantities.

Neither firm has any reason to change strategy. If the firm raises prices it will lose all its customers. If the firm lowers price P < MC then it will be losing money on every unit sold.[16]

The Bertrand equilibrium is the same as the competitive result.[17] Each firm will produce where P = marginal costs and there will be zero profits.[14] A generalization of the Bertrand model is the Bertrand–Edgeworth model that allows for capacity constraints and more general cost functions.

According to this model, each firm faces a demand curve kinked at the existing price.[18] The conjectural assumptions of the model are; if the firm raises its price above the current existing price, competitors will not follow and the acting firm will lose market share and second if a firm lowers prices below the existing price then their competitors will follow to retain their market share and the firm's output will increase only marginally.[19]

If the assumptions hold then:

The firm's marginal revenue curve is discontinuous (or rather, not differentiable), and has a gap at the kink[18]

For prices above the prevailing price the curve is relatively elastic[20]

In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization. Market shares in an oligopoly are typically determined by product development and advertising. For example, there are now only a small number of manufacturers of civil passenger aircraft, though Brazil (Embraer) and Canada (Bombardier) have participated in the small passenger aircraft market sector. Oligopolies have also arisen in heavily-regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate.

Three leading food processing companies, Kraft Foods, PepsiCo and Nestlé, together achieve a large proportion[vague] of global processed food sales. These three companies are often used as an example of "Rule of three",[25] which states that markets often become an oligopoly of three large firms.

Fixed line telecommunications products in Australia are primarily delivered by Telstra, Optus, TPG or increasingly NBN Co. Other brands are virtual network operators (VNO). In the mobile market there are three main operators, Telstra, Optus and Vodafone Hutchison Australia with other mobile virtual network operators (MVNO) selling access to those three networks.

The VHF Data Link market as air-ground part of aeronautical communications is controlled by ARINC and SITA, commonly known as the organisations providing communication services for the exchange of data between air-ground applications in the Commission Regulation (EC) No 29/2009.

In March 2012, the United States Department of Justice announced that it would sue six major publishers for price fixing in the sale of electronic books. The accused publishers are Apple, Simon & Schuster Inc, Hachette Book Group, Penguin Group, Macmillan, and HarperCollins Publishers.[36][37][38]

Above the kink, demand is relatively elastic because all other firms' prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point and the kink point. This is a theoretical model proposed in 1947, which has failed to receive conclusive evidence for support.

"Kinked" demand curves are similar to traditional demand curves, as they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend–"kink". Thus the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve.

Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.

The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. This is because competitors will generally ignore price increases, with the hope of gaining a larger market share as a result of now having comparatively lower prices. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less so for price decreases. Theory predicts that firms will enter the industry in the long run.